Emerging Economies During and After the Great Recession

Philip Arestis, M. Sawyer, Philip Arestis, M. Sawyer

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137485557
• Topic: Business
• Subtopic: Business internazionale
• Index: Business

The International Papers in Political Economy (IPPE) series explores the latest developments in political economy. This twelfth volume presents a collection of eight papers, analysing the emergence and economic problems of the emerging economies during and after the international financial crisis of 2007–8 and the subsequent Great Recession.The contributions range from an analysis of the international financial crisis of 2007–8 in general terms to an analysis of the same but concentrating on the emerging economies, before turning to groups of economies, Arab, African and Eastern European countries, and two relevant but individual countries, namely China and Turkey.This book offers students, scholars, researchers and policy-makers detailed analysis and informed commentary on the origins of the international financial crisis of 2007–8 and the great recession by focusing on its effect on emerging countries.

1

Main and Contributory Causes of the Recent Financial Crisis and Economic Policy Implications

Philip Arestis

University of Cambridge, UK, and University of the Basque Country, Spain

Abstract: We locate the main causes of the recent financial crisis on three factors. The first two of these were financial liberalization and its associated distributional effects (redistribution from wage earners to the financial sector) in the US and elsewhere. Both of these factors gave substantial impetus to the development and extension of new forms of securitization and the use of derivatives. This financial engineering practice, the third main factor, led to the growth of the instruments labelled as collateralized debt obligations (CDOs), particularly in the form of collateralized mortgages. There were also three contributory factors, which exacerbated the process of the main causes: the international imbalances, mainly as a result of the growth of China; the monetary policy pursued by countries over the period leading to the crisis; and the role played by the credit rating agencies. We discuss the economic policy implications of the financial crisis before we summarize and conclude.

Keywords: Financial Crisis, Main and Contributory Causes, Economic Policy Implications, Coordination of Economic Policies

JEL Classification: D30, E44, E58, E60

1.1 Introduction¹

We discuss the origins of the recent financial crisis, which began in the US in the autumn of 2007 and spread to 2008 and 2009, and subsequently led to the ‘Great Recession’. In doing so, we distinguish between main factors and contributory factors. The main factors contain three key features: distributional effects, financial liberalization and financial innovation. The contributory factors also contain three features: international imbalances, monetary policy, and the role of the credit rating agencies. In discussing the origins of the current crisis we are very much aware of the limitations of current macroeconomics. Indeed, we agree with Minsky (1982), who argued about three decades ago that “from the perspective of the standard economic theory of Keynes’s day and the presently dominant neoclassical theory, both financial crises and serious fluctuations of output and employment are anomalies: the theory offers no explanation of these phenomena” (p. 60; see, also, Arestis, 2009; and Palley, 2012).

The recent financial crisis and the ‘Great Recession’ that ensued were caused by US financial liberalization, which helped significant income redistribution effects from wages to the profits of the financial sector in the US; both features enabled and promoted the financial innovations that followed them. An interesting statistic on this score is reported in Philippon and Reshef (2009) with regard to the US. This is the pronounced above-average rise in the salaries of those employed in finance. Relative wages, the ratio of the wage bill in the financial sector to its full-time-equivalent employment share, enjoy a steep increase over the period mid-1980s to 2006. What explains this development is the policy of deregulation, followed by the rapid expansion in financial innovation. The deregulation impact, according to the authors, accounted for 83 per cent of the change in wages. Indeed, wages in the financial sector are higher than in other sectors, even after controlling for education.

The three contributory factors are suggested as features that promoted, rather than caused, the ‘financial crisis’. We take the view that although these factors were important, they were not its main causes. Rather, they were accentuating the process of the main causes rather than being part of the main factors of the crisis. We also discuss the economic policy implications of the financial crisis and the ‘Great Recession’ before we finally summarize and conclude. It should be noted at this early stage that the focus of this contribution is on the US economy and experience.

1.2 Main factors

We begin with the distributional effects as one of the main causes.

1.2.1 Distributional effects

The steady but sharp rise in inequality from around the 1980s (see, for example, Atkinson, 2015) is an important feature of this period.² Galbraith (2012a) suggests that “inequality was the heart of the financial crisis. The crisis was about the terms of credit between the wealthy and everyone else, as mediated by mortgage companies, banks, ratings agencies, investment banks, government sponsored enterprises, and the derivatives markets” (p. 4). In the US “The top 1 per cent of households accounted for only 8.9 percent of income in 1976, but this share grew to 23.5 percent of the total income generated in the United States by 2007” (Rajan, 2010, p. 8). Also, “The richest 1 percent of American households owned about 35 percent of national wealth in 2006–2007 ... a far greater share than in most other developed countries” (Wade, 2012, p. 12). Further evidence by Piketty (2014) shows that between the outbreak of World War I in 1914 and the 1970s, both levels of income inequality and the stock of wealth in the US fell dramatically. Since the 1970s, however, both income inequality and the stock of wealth have returned to the pre-1914 levels. Indeed, and as Piketty (op. cit.) suggests, in the past 30 years or so in the US nearly 75 per cent of the aggregate income growth has gone to the top of the distribution. Still further evidence by Atkinson et al. (2011) shows that the share of US total income going to the top income groups had risen dramatically prior to 2007. The top pre-tax decile income share reached almost 50 per cent by 2007, the highest level on record. The share of an even wealthier group – the top 0.1 per cent – more than quadrupled from 2.6 per cent to 12.3 per cent over the period 1976 to 2007. Real wages had fallen even behind productivity well before the onset of the ‘Great Recession’ (we may note that in the US wages constitute the most important component of incomes). The share of the top 5 per cent total income of households increased from 22 per cent in 1983 to 34 per cent in 2007; and household debt to GDP ratio over the period 1983–2008 almost doubled (Kumhof and Rencière, 2010a; see also 2010b). Indeed, and as Piketty (2014) shows, the income share of the top 1 per cent in English-speaking countries (especially in the US) has risen since 1980; the same 1 per cent appropriated 60 per cent of the increase in US national income between 1977 and 2007. The declining wage and rising profits share were compounded by the increasing concentration of earnings at the top, especially in the financial sector.³

The IMF managing director and the governor of the Bank of England have clearly stated at a conference in London (‘Inclusive Capitalism’, 27 May 2014) that rising inequality is a threat to economic growth and financial stability. The IMF managing director (Lagarde, 2014) made the point that “One of the leading economic stories of our time is rising income inequality, and the dark shadow it casts across the global economy” (p. 11). The IMF managing director went on to suggest that “The facts are familiar. Since 1980, the richest 1 percent increased their share of income in 24 out of 26 countries for which we have data. In the US, the share of income taken home by the top one percent more than doubled since the 1980s, returning to where it was on the eve of the Great Depression. In the UK, France, and Germany, the share of private capital in national income is now back to levels last seen almost a century ago” (p. 11). The Governor of the Bank of England (Carney, 2014) clearly stated in his speech that “Bankers made enormous sums in the run-up to the crisis and were well compensated after it hit. In turn, taxpayers picked up the tab for their failure. That unjust sharing of risk and reward contributed directly to inequality but – more importantly – has had a corrosive effect on social fabric of which finance is part and on which it relies” (p. 36).

Turning to the share of profits in relation to income in the case of the US, the following comments are very relevant. We note that profitability at the end of 2001 fell to an all-time low. This may have been the result of shifting production abroad, due to the increasing challenge of the US from other industrialized countries, such as Japan, Europe and especially China. It all gathered pace in the era of globalization. However, the picture of profits is not shared by financial companies. The share of the financial sector to GDP almost doubled in size between 1981 and 2007, and more recently accounted for 8 per cent of US GDP (Philippon, 2008). Between 1981 and 2007 the US financial sector, as measured by the ratio of private credit to GDP, grew from 90 per cent to 210 per cent. In addition, a sharp, nearly sixfold increase occurred, in their profitability since 1982. Indeed, and over the same period, as we have stated earlier wages in the financial sector were higher than in other sectors, even after controlling for education (Philippon and Reshef, 2009). Financial sector relative wages, and the ratio of the wage bill in the financial sector to its full-time-equivalent employment share, enjoyed a steep increase over the period mid-1980s to 2006.⁴

The redistribution feature was helped greatly by attempts at financial liberalization in many countries around the world. Of particular importance for our purposes was the financial liberalization framework in the US, especially following the repeal of the 1933 Glass–Steagall Act in 1999. Both the redistribution and the financial liberalization policies led to a period of financial engineering in the US, which spread worldwide to produce subsequently the ‘Great Recession’. We turn our attention next to the subject of financial liberalization.

1.2.2 Financial liberalization

The US experienced financial liberalization from around the mid-1970s. In 1977 the authorities introduced the deregulation of commissions for stock trading, and subsequently investment banks were allowed to introduce unsecured current accounts. This was followed in the 1980s by the removal of Regulation Q, that is, the removal of ceilings on retail-deposit interest rates. The repeal of the key regulation Glass–Steagall Act of 1933⁵ in 1999 (promoted by the US financial sector, who used as their main argument the experience of the so-called Big Bang of 1986 in the UK) was the most important aspect of the US financial liberalization for the purposes of the question in hand.⁶ The final step in the process was another major and relevant legislative phase, which was the repeal of the Shed–Johnson jurisdictional accord of 1982, which banned regulation of over-the-counter derivatives. That repeal was enacted through the Commodity Features Modernisation Act (CFMA) of December 2000; it is also the case that “In the 2000s deregulation was followed by desupervision, as US regulatory authorities made calculated decisions not to investigate financial-sector practices” (Galbraith, 2012b, p. 4).

However, the repeal of the 1933 Glass–Steagall Act that took place in 1999 was the apotheosis of the financial liberalization in the US. The 1933 Glass–Steagall Act had been designed to avoid the experience of the 1920s in terms of the conflict of interest between the commercial and the investment arms of large financial conglomerates (whereby the investment branch took high levels of risk tolerance). The ultimate aim of the 1933 Glass–Steagall Act had been to separate the activities of commercial banks and the risk-taking ‘investment or merchant’ banks along with strict regulation of the financial services industry. In effect, the Glass–Steagall Act of 1933 broke up the most powerful banks. The goal was to avoid a repetition of the speculative, leveraged excesses of the 1920s/1930s. The repeal of the Act in 1999 enabled investment banks to branch into new activities, and allowed commercial banks to encroach on the investment banks’ other traditional preserves. Not just commercial banks but also insurance and other companies, like the American International Group (AIG), were also involved in the encroaching.⁷

All these financial liberalization attempts were important in promoting financial innovations in the US financial markets. In our analysis we discuss their importance before turning our attention to the financial engineering that emerged directly from them and led to the financial crisis.

When fixed commissions were in place, investment banks would book stock trades for their customers; deregulation meant greater competition, entry by low-cost brokers and thinner margins. Then, in the late 1970s, investment banks were allowed to invade the commercial bank territory, through the creation of ‘money market’ accounts (current accounts that were unsecured). Removing Regulation Q allowed fluctuations in interest rates, thereby forcing commercial banks to compete for deposits on price, which led them to pursue new lines of business. Such new business was in response to the investment banks’ needs for short-term funding. It created, however, a financial crisis in the 1970s and 1980s when savings banks and loans could not fund themselves as a result of the narrowing of the margins of lending and borrowing rates. Investment banks moved into originating and distributing complex derivative securities, such as collateralized bond obligations (normal investment bonds backed by pools of junk bonds). However, that was not a great success and the move collapsed in the second half of the 1980s, and that occurred in view of the wide fluctuations in the backed bond prices.⁸

However, that originate-and-distribute failure was followed by a new initiative of asset-backed and mortgage-backed securities, which gained a clientele in the 1990s. That was enabled in part by the relaxing of the 1933 Glass–Steagall Act in 1987, when the Federal Reserve Bank (the Fed) allowed 5 per cent of bank deposits to be used for investment banking, and then further promoted in 1996 when 25 per cent of deposits were allowed for the same purpose. In further developments 1997 saw the introduction of the Broad Index Secured Trust Offering (BISTRO), a bundle of credit derivatives based on pools of corporate bonds, and later there was also the launch of other types of financial derivatives, Collateralized Mortgage Obligations (CMOs), based on pools of subprime mortgages, and Collateralized Debt Obligations (CDOs) based on other debt.⁹ BISTRO was not a great success in view of the corporate sector’s booms and recessions at that time. However, CMOs and CDOs, which were based on mortgages and other assets, were received favourably due to the steady growth of the housing and other relevant markets. This was to prove one of the main causes of the financial crisis: the originate-and-distribute model of securitization and the extensive use of leverage.

1.2.3 Financial innovation

The repeal of the 1933 Glass–Steagall Act in 1999 enabled investment banks to branch out into new activities, and it allowed commercial banks to encroach on the investment banks’ other traditional preserves. It was not just commercial banks that were involved in this encroaching. Insurance companies, such as the American International Group (AIG), and hedge funds were also heavily involved. Haldane (2010, Chart 2) shows clearly that the 1933 Act was effective from the 1930s to the late 1980s¹⁰ when, as mentioned above, the US authorities began to relax it at the same time as the redistribution effects and the attempts at financial liberalization. In fact, concentration in the US banking sector remained flat over that period. The revoke of the restrictions of the 1933 Glass–Steagall Act in 1999 with the Gramm–Leach–Bliley Act, thereby allowing the co-mingling of commercial and investment banking, and finally the repeal of the 1933 Act in 1999, which allowed commercial and investment banks to mingle together, had the dramatic effect of increasing the share of the top three largest US banks from 10 per cent to 40 per cent between 1990 and 2007 (Haldane, 2010, p. 9). Interestingly enough, that dramatic increase in the size of the US banking is not mirrored by similar effects in other industries. Haldane (op. cit.) shows that “The largest banking firms are far larger, and have grown faster, than the largest firms in other industries”, so that “the too-big-to-fail problem has not just returned but flourished” (p. 9). Furthermore, Haldane (op. cit.) argues that “A similar trend is discernible internationally: the share of the top five largest banks in the assets of the largest 1000 banks has risen from around 8 percent in 1998 to double that in 2009” (p. 9).

Another interesting and relevant observation is that the non-bank less regulated and supervised mortgage lenders contributed disproportionately to the boom in mortgages. Dagher and Fu (2011) demonstrate this proposition and show that while in 2003 the non-bank mortgage lenders accounted for only around one-third of mortgage lending, they contributed more than 60 per cent to the increase in mortgage lending between 2003 and 2005. The same authors have suggested, therefore, that the exercise of more stringent regulation could have averted some of the volatility in the housing market.

The repeal of the Glass–Steagall Act in 1999 allowed the merging of commercial with investment banking, the...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of Figures
• List of Tables
• Preface
• Notes on the Contributors
• 1 Main and Contributory Causes of the Recent Financial Crisis and Economic Policy Implications
• 2 The Emerging Economies and the Great Recession
• 3 Africa and the Great Recession: The Dynamics of Growth Sustainability
• 4 Arab Countries in Transition in the Aftermath of the Great Recession: The Policy Options
• 5 The Impact of the Great Recession and Policy Responses in Latin America: Was This Time Different?
• 6 An Eastern European Perspective on the Recent Financial Crisis and an Examination of Poland’s Exceptionalism
• 7 China Confronts the Great Recession: ‘Rebalancing’ Neoliberalism, or Else?
• 8 The Political Economy of Inequality and Boom-Bust Cycles in Turkey: Before and After the Great Recession
• Index